HOW TO ANALYSE STOCKS IN DEPTH

ANALYSING A COMPANY- STOCK ANALYSIS BASICS, STEP-BY-STEP

Learning to do an in-depth stock analysis is not rocket science. Here's a step-by-step process that can be followed by any beginner stock enthusiast.

Pat Dorsey, Director of Stock Analysis, Morningstar Inc. in his very useful book -The Five Rules for Successful Stock Investing - suggests breaking down the process of evaluating the quality of a company into five areas -Growth, Profitability, Financial Health, Risks/Bear Case, and Management. These are the key areas to focus on when you are looking to do a stock analysis. His writings are the primary source for this article.

One word of caution, the following discussion is concerned only with evaluating the quality of the company. However, this is only half the story because even the best companies are poor investments if purchased at too high a price. Estimating the right price to pay for a company's shares- or Stock Valuation is the other half of the story.

GROWTH

Anyone looking to do a stock analysis for a company is probably attracted to it because of its Growth. The allure of growth has probably led more investors into temptation than anything else. High growth rates are heady stuff - a company that manages to increase its earnings at 30% for five years will triple its profits, and who wouldn't want to do that? Unfortunately a slew of academic research shows that strong earnings growth is not very persistent over a series of years; in other words a track record of high growth earnings growth does not necessarily lead to high earnings growth in the future.

Why is this? Because strong and rapidly growing profits attract intense competition. Companies that are growing fast and piling up profits soon find other companies trying to get a piece of the action for themselves.

You can't just look at a series of past growth rates and assume they'll predict the future - if investing were that easy, money managers would be paid much less!. And this stock analysis much shorter. Its critical to investigate the sources of a company’s growth rate and assess the quality of the growth. High-quality growth that comes from selling more goods and entering new markets is more sustainable than low-quality growth that's generated by merely cost-cutting or accounting tricks. 

Sources of Growth

Investigating the sources of growth is an important element in any stock analysis framework. How to look for sources of growth? In the long run, sales growth drives earnings growth. Although profit growth can out pace sales growth for a while if the company is able to do an excellent job of cutting costs or fiddling with the financial statements, this kind of situation isn't sustainable over the long haul - there's a limit to how much costs can be cut, and there are only so many financial tricks that companies can use to boost the bottomline. In general, sales growth stems from one of four areas:1. Selling more goods or services2. Raising prices3. Selling new goods or services4. Buying another company  

Quality of Growth

There are many ways of making growth look better than it really is, especially when we turn our attention to earnings growth rather than sales growth. (Sales growth is much more difficult to fake).

In general, when you are doing a stock analysis - any time that earnings growth outstrips sales growth by far, over a long period - for over 5-10 years - you need to dig into the numbers to see how the company keeps squeezing out more profits from lackluster sales growth. Stock analysis for sustainability of that growth becomes that much more critical. A big difference in the growth rate of net income and operating income or Cash flow from Operations can also hint at something unsustainable.

Any time you can't pinpoint the sources of a company's growth rate - or the reasons for a sharp divergence between the top and bottom lines, you should be wary of the quality of that growth rate.

PROFITABILITY

Now we come to the second-and in many ways, most crucial-part of the stock analysis process. How much profit is the company generating relative to the amount of money invested in the business? This is the real key to separating great companies form average ones. The higher the return, the more attractive the business.

Return on Assets (ROA)

We know the first component of ROA. Its simply Net Margin, or Net Income divided by Sales. And it tells us how much of each dollar of sales a company keeps as earnings, after paying all the costs of doing business. The second component is Asset Turnover, or Sales divided by Assets, which tells us roughly how efficient the firm is at generating revenue from each dollar/rupee of Assets.

Multiply these two, and we have Return on Assets. Net Income/Sales =Net Margin and Sales/Assets =Asset Turnover

ROA = Net Margin x Asset Turnover

Think of ROA as a measure of efficiency. Companies with high ROAs are better at translating Assets into Profits. ROA helps us understand that there are two routes to excellent operational profitability. You can charge high prices for your products (high margins) or you can turn over your assets quickly.

Rough benchmarks for stock analysis - ROA

All things being equal, the more asset-intensive a business, the more money must be reinvested into it to continue generating earnings. This is a bad thing. If a company has a ROA of 20%, it means that the company earned $0.20 for each $1 in assets. As a general rule, anything below 5% is very asset-heavy [manufacturing, railroads], anything above 20% is asset-light [advertising firms, software companies].

Return on Equity (ROE)

Just using ROA would be fine, if all companies were big piles of Assets, but many firms are atleast partially financed with debt, which gives their returns a leverage component, which we need to take into account. ROE lets us do this.

Return on Equity is a great overall measure of a company's profitability because it measures the efficiency with which a company uses shareholders' equity. Think of it as measuring profits per dollar of shareholders' capital.

Multiply ROA by the firm’s Financial Leverage ratio, and you have its Return on Equity.

Financial Leverage =Assets/Shareholders' Equity and Return on Equity =Return on Assets x Financial Leverage. Because Return on Equity =Net Margin x Asset Turnover

ROE = Net Margin x Asset Turnover x Financial Leverage

Financial Leverage is essentially a measure of how much debt a company carries, relative to shareholders' equity. Unlike Net Margins & Asset Turnover, for which higher ratios are almost unequivocally better, financial leverage is something you want to watch carefully. As with any kind of debt, a judicious amount can boost returns, but too much can lead to disaster.

So, we have three levers that can boost ROE - net margins, asset turnover and financial leverage.

Rough benchmarks for stock analysis - ROE

In general, any non-financial firm that can generate consistent ROEs above 15 percent without excessive leverage is atleast worth investigating. As of mid 2008, only about 10% of the non-financial firms in ValuePickr database were able to post an ROE above 15% for each of the past 5 years, so you can see how tough it is to post this kind of performance. And if you can find a company with consistent ROEs over 30%, there's a good chance you are really onto something.

Two Caveats when using ROE for stock analysis

First, Banks always have enormous financial leverage ratios, so don't be scared off by a leverage ratio that looks high relative to a non-bank. Additionally, since banks' leverage is always so high, you want to raise the bar for financial firms - look for consistent ROEs above 18% or so.

Second caveat is about firms with ROEs that look to good to be true, because they are usually just that. ROEs above 50% or so are often meaningless because they have probably been distorted by the firm's financial structure. Firms that have been recently spun off from parent firms, companies that have bought back much of their shares, and companies that have taken massive charges of ten have very skewed ROEs because their Equity base is depressed. When you see an ROE over 50%, check to see if the company has any of these above-mentioned characteristics.

Free Cash Flow

Cash Flow from Operations measures how much cash a company generates. It is the true touchstone of corporate value creation because it shows how much cash a company is generating from year to year. As useful as the Cash Flow statement is, it does not take into account the money that a firm has to spend on maintaining and expanding its business. To do this, we need to subtract Capital Expenditures, which is money used to buy fixed assets.

Free Cash Flow =Cash Flow from Operations - Capital Expenditure

Free Cash Flow enables us to separate out businesses that are net users of Capital - ones that spend more than they take in- from businesses that are net producers of Capital, because its only that excess cash that really belongs to shareholders. Free Cash Flow is sometimes referred to as "Owners Earnings" because that's exactly what it is: the amount of money the owner of a company could withdraw from the treasury without harming the company's ongoing business.

Rough benchmarks for stock analysis - Free Cash Flow

As with ROE it’s tough to generalise how much free cash flow is enough. However its reasonable to say that any firm that is able to convert more than 10% of Sales to Free Cash Flow (just divide Free Cash Flow by Sales to get this percentage) is doing a solid job at generating excess Cash.

Profitability Matrix

One good way to think about the returns a company is generating is to use the Profitability Matrix, which looks at a company's ROE relative to the amount of free cash flow it's generating. This Matrix can tell us a great deal about the kind of company we are analysing.

Enough for today, will update later.